Using Ratios to Detect Fraud and Financial Misstatement

I have discussed various techniques and ratios to analyze a set of financial statements. On other hand, there are various techniques used to report financial statements fraudulently (overstate revenues, understate expenses, understate liabilities, overstate assets, and/or improperly disclose information) by unethical management. You may think that only auditor [or insider] of the company who have full access to the financial data are able to detect such fraudulently. Wrong! An analysis of financial statement ratios that would be affected by these techniques can help identify potentially misstated financial statements literally by utilizing the four financial statement sets [balance sheet, income statement, equity statement and cash flow statement] alone published by the company without any needs to its raw financial data. How?

Through case examples presented in this post, I am going to show you how financial statement ratios are able to detect fraud and [or material misstatement]. Follow on…

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Main Indicators of the Financial Fraud and [or Misstatement]

First, here are the keys: Any changes in the financial statement ratios from one year to the next and over a period of time should make sense. Further, it’s reasonable to expect the ratios to be similar to industry averages unless there is a logical explanation for why they are not. Thus, if a company’s financial ratios are showing unusual fluctuations that cannot be explained rationally, especially if the ratios are out of line with industry averages, it may be a good idea to reconsider relying on those financial statements.

Industry averages can be obtained fairly easily online, although some Web sites require that an individual pay a subscription fee for their services. On a search engine such as Google, type in “industry averages” and hundreds of thousands of hits will emerge; there are plenty of resources available. One free Web site that provides some industry averages is yahoo finance. How do these work? Read on…

How Financial Statement Ratio Analysis Can Detect Fictitious Revenues

In the mid-1980s, Fakezone Co., Inc., perpetrated a massive financial statement fraud that fooled the auditors of one of the then largest international public accounting firms, along with Fakezone’s investors, who lost a reported $100 million. The company was a carpet cleaning business. Most of the fraud involved recording fictitious revenues and accounts receivable and was perpetrated to inflate the stock price when the company went public five years after its inception.

The company claimed to earn most of its revenues through lucrative insurance restoration jobs which involved cleaning and repairing buildings damaged by floods, fires, and other major catastrophes. However, the insurance restoration side of the business was entirely bogus, and only the carpet cleaning side of the company was legitimate (it represented approximately 2 percent of the company’s total revenue according to its fraudulent financial statements). When the auditors insisted on physically inspecting one multi-million-dollar insurance restoration site, Fakezone management found a large building under construction and was able to persuade the construction foreman to provide them with keys to the building for a weekend on the pretext that they were with a property management ? rm and were going to provide a tour to a prospective tenant. Before the auditors’ visit, they placed signs throughout the building indicating that Fakezone was the contractor for the building’s restoration.

This building had not been damaged—instead, it was under construction—but the plan went off without a hitch: The auditors were fooled. On another occasion, when the auditors insisted on visiting another multi-million-dollar restoration site, Fakezone had to lease some floors of a new building quickly. For the floors that weren’t completed, Fakezone spent approximately $1 million to make the space look realistic, hiring subcontractors to make the floors look restored. All this for a tour with the auditors that lasted perhaps 20 minutes.

However, the industry average was around 10 percent. Recall that nearly all of the sales revenue and related accounts receivable were fictitious in this case.

Consequently, the accounts receivable grew from $0 to nearly $700,000 the next year and approximately $2,500,000 only three months after that. Sales increased dramatically in one year from slightly over $1.24 million to just under $4.85 million, a 291 percent increase. In a company doing such booming business, cash increased only from approximately $30,000 to $87,000 during that period. However, almost half of the revenues that year were from only one insurance restoration job (which, of course, was a fake).

How could a financial statement reader know this?

When an internationally renowned public accounting firm—Fakezone’s auditors—couldn’t detect the fraud, it’s hard to criticize any financial statement reader. But perhaps the idea that this relatively new company was founded and run by a 20-year-old history major with minimal business education and experience should have raised some suspicions. The identity and basic background of a company’s CEO should not be a mystery to financial statement readers.

Other red flags were also present. For example, during the year when nearly $4.85 million in net sales was reported, general expenses of approximately $1.13 million also were reported on the income statement. Yet three months later the quarterly financial statements showed nearly $5.4 million in net sales (for three months) while general expenses decreased to approximately $622,000. Total assets on the balance sheet also were skyrocketing. In one year the reported total assets climbed from $178,000 to almost $5.1 million, an increase of over 2,700 percent. Further, the next quarter’s financial statements listed total assets of slightly over $8.2 million, which is an increase of over 4,500 percent from the base year only 15 months earlier. This is phenomenal, unheard-of growth.

How Ratios and Trend Analysis Detect Understated Sales Return

In the mid–1980s, management changed at Belle Company, Inc., a manufacturer of vacuum cleaners. New products were introduced which were less expensive to manufacture, but those vacuums had plastic parts that apparently often melted when the product was used for a period of time, rendering the vacuum cleaner useless. Consequently, the sales returns were increasing greatly, running as much as 16 percent of gross sales revenues.

The new CEO had a controlling interest in the company, and it had been his idea to meddle with Belle’s 100-year-old sterling reputation as a manufacturer of hardy, dependable vacuum cleaners. He had purchased his interest in the company by taking on a large amount of personal debt, and he needed Belle to be profitable so that he could make his debt payments. With the auditors coming soon and the warehouse filling up with returned merchandise, he decided to cook the books with the assistance of other members of management. He rented a warehouse elsewhere to store the useless returned vacuums and altered all the documentation indicating that the sales had been returned.

The sales returns were not reflected on the financial statements, and the auditors were fooled. However, this kind of fraud, with the underlying cause of an ineffective product, cannot continue indefinitely. Before long, word of the defective design began to spread among consumers, and sales began to drop. Eventually, the CEO realized he couldn’t continue to juggle the numbers and deceive the auditors. Like a house of cards, the company collapsed, and investors and creditors lost a reported $40 million.

The Belle Company, Inc.’s, financial statements is shown below:

Recall that in this case the vacuum cleaners with the revised product design featuring internal plastic parts were being returned at a fast rate because the plastic parts were melting when the vacuum was operated. Management chose not to book those sales returns properly, which would have reduced the income statement’s reported net sales.

Consequently, the income statements for three consecutive years showed net sales increasing from approximately $76 million to $128 million to $181 million (increases of 68 percent and 138 percent over the first year). At the same time, cost of goods sold was reported at $46 million, $71 million, and $95 million (increases of 53 percent and 105 percent over the first year). As a result, the gross profit margin changed from approximately 39.3 percent to 44.8 percent to 47.6 percent. Were these increasing gross profit margins due to a more efficient manufacturing process for the revised vacuums, or did they occur because the cost to manufacture vacuum cleaners with plastic parts was lower than the manufacturing costs for the earlier models with steel parts?

Either explanation is rational, but when one also looks at days inventory supply for Belle, a concern arises. Specifically, for the same years, the “days inventory” supply changed from 77 to 76 to 113. Does this suggest sluggish sales? Inventory increased from $9.7 million to $19.6 million to $39.1 million during those three years, when reported total assets changed from $43.2 million to $65.2 to $118.1 million.

Perhaps many sales were on account, and if that was the case, how quickly were the accounts receivable being collected? In Belle’s case, the accounts receivable increased from approximately $14 million to $28 million to $51 million. The resulting “days sales” outstanding increased from 69 days to 79.1 days to 102.9 days. Was it taking longer to collect the receivables because customers were disputing what they owed for those returned faulty products?

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